Cyclical and Turnaround Stocks: There Is A Lot Of Value In This Market: Part 5

This article represents the final installment in our "There Is A Lot of Value
In This Market" series. Links to parts
one through four can be found here. In some ways, this article represents
prima fascia evidence supporting some of our main hypotheses. First of all,
this article will clearly support the notion that not all common stock are
the same, and therefore, they should all not be painted with the same broad
brush stroke (generalities or opinions). The examples in this article will
clearly illustrate just how different individual companies are. Therefore,
this further validates the notion that each company should be evaluated on
its own individual merit, thereby validating the concept that it is a market
of stocks and not a stock market.

Furthermore, this article will present a significant challenge regarding how
to properly calculate fair valuation on cyclical or semi-cyclical companies.
The real issue with cyclical companies is having the confidence regarding what
future earnings might be. In other words, even when consensus estimates are
positive, the prudent investor must ask themselves - how long can it last?
Moreover, the answer can vary dramatically from one company to the next. In
other words, depending on exactly how cyclical the company is and how cyclical
its industry is, will ultimately determine whether earnings are to continue
rising for a while or suddenly fall out of bed. This is the treachery with
investing in cyclical stocks. Sometimes they can be very rewarding, and sometimes
they can cut the legs right out of your portfolio's performance.

Turnaround Stocks: High Risk or High Reward?

The first equity classification we are going to look at we will define as
turnaround situations. This implies a company that, after struggling with significant
operating issues, is set to turn its business around. It's important to state,
that these are typically not your everyday buy-and-hold kind of stocks. Instead,
these tend to be higher risk opportunities that will often only warrant a short-term
holding. To put this into perspective, these are the situations that offer
a high degree of profit potential, but simultaneously at a high degree of risk.
Consequently, they would not be for consideration as a core holding, that might
represent opportunities for what some investors like to call their play money.

Is Goodyear Tire & Rubber (GT) A Turnaround Opportunity?

Our first example will be Goodyear Tire & Rubber. A quick glance at the
20-year F.A.S.T. Graphs™ on
this company tells us a great deal about its business instantaneously. For
example, we can see that it has been very challenging for this company to maintain
any type of profitability. We see that profits began collapsing in the late
1990s, and we also see that price followed. This validates the idea that earnings
determine market price in the long run. Another important perspective that
this graphic illustrates is how the company quit paying its dividend in 2003.
The light blue shaded area indicates dividends, and visually we see that they
disappear.

Since 2003 we see a very cyclical and spotty record of earnings volatility.
This begs an important question that a prudent investor should ask. How much
can I trust this company's future earnings potential? In other words, forecasting
future earnings for this company would be very difficult, to say the least.

A quick look at the long-term track record of this company with deteriorating
long-term earnings results validates our notion that this is not a buy-and-hold
candidate. If you are an investor that believes that the strategy buy-and-hold
is dead, then this company could be your poster child. As the performance report
reveals, this company has destroyed shareholder value since 1994.

Yet, and on the other hand, after a company has generated very weak results,
it can often be very easy to generate very high future growth if the business
has any earnings power at all. Therefore, our next graph on Goodyear shows
an extremely high rate of earnings growth simply because earnings are coming
off of such a low base. But, and this is a very important but, we believe this
also represents a classic example of how statistics, or put another way, a
representation based on just numbers, can be very misleading. Because, it is
a fact that since 2010, Goodyear has generated an extraordinary earnings growth
rate in excess of 45% per annum.

Furthermore,an observation that we have noticed after reviewing thousands
of examples, is that future earnings estimates will tend to have a built-in
bias based on recent results. In the case of Goodyear, the consensus earnings
estimates of nine analysts reporting to Capital IQ estimate five-year earnings
growth of 46.3% per annum, a number that is very close to what it has achieved
over the past four years or so.

Microsoft MSN Goodyear Tire Forecast From Zacks

A cross-check look from another source corroborates what Capital IQ analysts
are forecasting. Below is a screenshot from Microsoft MSN illustrating the
consensus five-year estimated earnings growth rate on Goodyear by seven analysts
reporting to Zacks. Interestingly, the estimate is identical to Capital IQ.
However, it seems too much of a coincidence that this number mirrors recent
history so closely to not consider it biased.

General Electric (GE): A Turnaround That Is Succeeding

When we look at the long-term operating history of General Electric we see
a company that was once a classic example, or even the epitome, of a blue-chip
dividend growth stock. However, since the company had built in a very large
financial division, everything changed as the financial industry instigated
the great recession of 2008. As we can clearly see, General Electric's earnings
collapsed during 2008 and 2009. However, earnings growth has been recovering
since, as we will see with our next graphic.

Since calendar year 2010, General Electric's earnings have staged a very respectable
rebound averaging growth of 12.3% per annum. It's also very important and useful
to note that stock price has followed suit and has closely tracked the resurgence
in earnings growth. Also, notice that the great recession that actually brought
General Electric's stock price in line with fair value based on these resurging
earnings.

As a result of the turnaround in General Electric's business, investors who
had the foresight to buy the company expecting a turnaround were well rewarded.
After the dividend was literally cut in half in 2009, it has once again begun
growing again. Moreover, since share price has closely tracked General Electric's
recovery earnings, capital appreciation of 16% per annum has been exceptional.
Add in the once again rising dividend and shareholders have enjoyed an 18.8%
rate of return since the beginning of calendar year 2010. This validates the
notion that turnarounds can represent exciting and profitable opportunities.

Cyclical Stocks: A Roller Coaster Ride To Riches Or The Poor House?

Cyclical stocks are different than turnarounds. A cyclical stock is a company
that has a legacy of its business routinely going through cycles of boom or
bust. A true cyclical company can provide investors great profits during the
good times, and conversely destroy a portfolio's performance during the bad.

Textron Inc. (TXT)- When It's Good It Is Very Good, When It's Bad It Is Very
Bad

Let's examine the long-term historical record of Textron Inc. (TXT) since
1994 to see a quintessential example of a cyclical stock in action. You will
see that when Textron's earnings are strong and growing, stock price follows
suit. Conversely, during the times when earnings are falling off a cliff, so
do stock prices. The point being that if you can pick a stock when earnings
are poised for an intermediate term advance, there are great profits to be
had. However, the hat trick is finding when to get out before the music stops.
Although that is easier said than done, timing does not have to be perfect,
but it does need to be reasonably responsive. In other words, waiting around
too long validates the old adage "he who hesitates is lost."

In order to get a perspective of how profitable a cyclical stock can be when
things are going right, our next graph looks at Textron from calendar year
2002 through calendar year 2007. This was a six-year time frame when earnings
growth was averaging 28.5% per annum, and when the company's beginning valuation
was in alignment.

Therefore, shareholders in Textron during these profitable years were highly
rewarded. Capital appreciation generated 22.9% per annum compounded return,
and the addition of its dividend, paid but not reinvested, increase the annual
rate of return to over 24% per annum.

On the other hand, if you own a cyclical stock during the bad side of a cycle,
like the last six years have been for Textron, it can be a devestating investment.
The following graphic looks at Textron since the great recession of 2008 where
we see the company's earnngs collapsing and stock price following it down.
However, since calendar year 2010, Textron's business and stock price have
been on a recovery trajectretory.

It's amazing what a difference owning a cyclical stock during the bad times
can make. The following performance since calendar year 2008 (the great recession)
shows that shareholder returns were abysmal. Both capital appreciation and
dividend income were negative during this period.

Currently, the consensus of 14 analysts reporting to Capital IQ, expect Textron
to once again grow earnings in excess of 28% per annum. If this truly is, as
Yogi Berra would say, déjà vu all over again, then this may be
a good opportunity to invest in Textron.

A cross-check with Microsoft MSN corroborates that the consensus of analysts
reporting to Zacks also expects similar five-year earnings growth at 26% per
annum. Although this instills some confidence that there is at least a reasonable
consensus, let us remind you of the warning we expressed with our Goodyear
Tire example above. In other words, at the end of the day it's always up to
us to determine whether or not we think the estimates are reasonable and achievable
or not. Our future returns will be a function of what the future investment
results turn out to be adjusted for valuation.

Microsoft MSN Textron Inc. Forecast From Zacks

Manitowoc Co. (MTW) and Caterpillar (CAT)

Our final two examples review the historical records of Manitowoc Co., a leading
manufacturer of building cranes and a major player in food service equipment,
and Caterpillar, who needs no introduction. Although both of these companies
would clearly meet our definition of cyclical, the earnings and price correlated
graphs on each show that they are different, yet in some ways the same. Both
graphics illustrate that these companies are sensitive to economic cycles,
you can clearly see how profits rise and fall with the economy. But even more
importantly, you can clearly see how stock prices logically react to those
same cycles.

Summary & Conclusions

As we conclude this series of articles, we hope that readers have at least
been given the perspective that not all common stocks are the same. More importantly,
we also tried to illustrate that it is not the stock market that ultimately
drives the returns of individual companies. Instead, it is the individual operating
results of each respective company that will reward shareholders in accordance
with the business results that individual companies have achieved on their
behalf.

Therefore, the final message is to encourage investors to quit worrying about
what the market might do or what the economy is going to do. Instead, try to
identify really great businesses where you like the management and the price.
Long-term investment performance will follow long-term operating performance.
Try to keep your emotions in check, try to filter out all the noise that you
are bombarded with every day, and try to make intelligent investing decisions
on facts. Because, as we have often stated, the problem with following the
herd is that your ultimate destination is the slaughterhouse.

Charles (Chuck) C. Carnevale is the creator of F.A.S.T. Graphs™. Chuck
is also co-founder of an investment management firm. He has been working in
the securities industry since 1970: he has been a partner with a private NYSE
member firm, the President of a NASD firm, Vice President and Regional Marketing
Director for a major AMEX listed company, and an Associate Vice President and
Investment Consulting Services Coordinator for a major NYSE member firm.

Prior to forming his own investment firm, he was a partner in a 30-year-old
established registered investment advisory in Tampa, Florida. Chuck holds a
Bachelor of Science in Economics and Finance from the University of Tampa.
Chuck is a sought-after public speaker who is very passionate about spreading
the critical message of prudence in money management. Chuck is a Veteran of
the Vietnam War and was awarded both the Bronze Star and the Vietnam Honor
Medal.

Disclaimer: The opinions in this document are for informational and
educational purposes only and should not be construed as a recommendation to
buy or sell the stocks mentioned or to solicit transactions or clients. Past
performance of the companies discussed may not continue and the companies may
not achieve the earnings growth as predicted. The information in this document
is believed to be accurate, but under no circumstances should a person act
upon the information contained within. We do not recommend that anyone act
upon any investment information without first consulting an investment advisor
as to the suitability of such investments for his specific situation.